Two-Year Interest-Rate Swap Spread Closes at 18-Year High

The spreads on two-year U.S. interest rate swaps widened to record levels Tuesday on growing credit fears and rising short-term interbank loan rates. The two-year swap spread traded as wide as 101.25 basis points before settling at 97 basis points versus 96 on Monday. The last record spread was 97 basis points in March 1989, during the savings-and-loan crisis. The five-year spread widened six basis points to 95.75 and the 10-year spread seven basis points to 80.75. "The widening of swap spreads is a function of tight lending and a de-leveraging in the financial system and the high cost of money," said William O'Donnell of UBS Securities. "The last two times we saw these meteor-like spikes in swap spreads in the U.S., they were followed by a recession." Banks are increasingly reluctant to lend to one another, as reflected in the rise of the three-month LIBOR rate on dollar deposits to 5%, its highest in three weeks and fifth consecutive daily increase. Tuesday saw an acceleration of investors' flight to safety, spurred in part by a report of heavy subprime losses at mortgage finance company Freddie Mac (full story). "As long as the liquidity crisis goes on, with Libor rates rising, and people keep buying Treasuries, these spreads will remain wide," said Fidelio Tata of RBS Greenwich Capital. "Banks, and financial institutions in general, are short credit and really don't want to lend. It won't get much better until after year-end."